Downgrades unlucky, or just plain careless?

IN THE Importance of Being Earnest, Lady Bracknell describes the loss of one parent as a misfortune, but to lose both looks like carelessness. Applying a similar principal to insurance giant QBE, which has made two insurance profit margin downgrades in the past 12 months, one can only wonder what Lady Bracknell would have concluded.

For investors, it was another disappointment from a company that has lately built a reputation for issuing bad news. QBE issued an insurance margin downgrade in January, followed it up with a minor adjustment in August and then slashed its second-half margin forecast on Monday.

QBE's new boss John Neal blamed the latest downgrade on superstorm Sandy, which he estimated would cost QBE between $350 million and $450 million.

Sandy and other issues in its US division forced Neal to cut profit guidance by hundreds of millions of dollars and slice the group's insurance profit margin by more than one-third to 8 per cent, after reconfirming three weeks ago that its margin would be at least 12 per cent.

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While Sandy happened on October 29, the 4 per cent slide in insurance margins cannot solely be sheeted home to the storm, nor can the slashing of its profit forecasts. The brutal reality is that behind Sandy are other issues in the US, the latest of which is a $US1.1 billion run-off on part of its US business and the need to raise $US500 million to prop up its reserves in the US.

In a teleconference Neal opened up with an apology to shareholders and played up the impact of hurricane Sandy. But the board also needs to look at its role in QBE in the past few years.

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There is there is a dearth of insurance experts on the board and many, including the chairwoman Belinda Hutchinson, have been on the board a long time.

The truth is the past year has been relatively quiet in terms of natural disasters and most of QBE's recent woes boil down to a string of US acquisitions under the watch of former chief executive Frank O'Halloran, who left the post in August after initially agreeing to join the board. During his 14-year tenure, O'Halloran made more than 100 acquisitions around the world.

These US acquisitions now account for 35 per cent of QBE's group revenue and can only be described as a festering sore.

Leading insurance analyst Brett Le Mesurier at BBY said he wasn't surprised at the extent of the increase in reserves required yesterday. ''A part of the business was put into run-off. I previously estimated the program and intermediary business didn't contribute much to profit in the first half and now we can see part of it is in run-off,'' he said.

Le Mesurier said he didn't expect margins to pick up any time soon partly due to potential problems with QBE's forced placed mortgage insurance business in the US, which is part of an industry-wide investigation by New York State's Department of Financial Services. This is in addition to the problems in the broader US business which are proving very difficult to fix.

Since December 2007, when its insurance margin was 22 per cent, QBE has suffered from eight half-yearly insurance margin declines in a row. The insurance margin bounced back from 4 per cent in the second half of 2011 to 13 per cent in the first half of 2012 and will slump to 3 per cent in the second half of 2012.

Over the same period, the group's share price has fallen more than 64 per cent - compared to a 30 per cent fall in the overall market - and its return on equity has more than halved from 23 per cent to an estimated 11 per cent in 2012, which is barely giving shareholders a return above the market cost of capital.

Falling margins and rising gross written premiums (which have increased more than 50 per cent since December 2007) raise questions about the company's strategy of acquisitions. While premiums have increased, insurance profits have gone backwards and in the US we have been told that it is now suffering from a deterioration in its crops business and a portfolio of 6000 claims reserves has been placed into run-off. This has resulted in an increase in claims provisions of the run-off portfolio by $180 million. A business turns to run-off when it has run out of opportunities to achieve a reasonable return.

QBE now estimates total large individual risk and catastrophe claims including provisions for specific incurred but not reported claims of $1.89 billion for the year. This is equivalent to 12 per cent of net earned premium. Prior year claims of $380 million have been allocated for any claims that might emerge from prior years.

The announcement comes a month after a group of analysts went on a roadshow with the company to the US and Europe, with a number of them painting a rosy picture for the company's US operations.

Not surprisingly, it has left more than a few analysts wondering why the company did not flag what was going on, particularly in its decision to run off some claims in the US.

The problem with QBE is writedowns and downgrades have become a recurring theme. Neal has a lot on his plate to restore investor confidence in a business that was once a market darling and is fast becoming a market pariah.